Types of Risk in Financial Institutions

sonal gupta

Risk is a common aspect in financial markets and can come from many sources. These include market, liquidity, and credit risks.

Market risk arises from the change in prices of financial instruments like stocks and bonds. It can also be due to changes in interest rates or exchange rates.

Credit Risk

Credit risk is the potential for a financial institution to lose money due to a borrower’s failure to repay debt obligations. This risk can be associated with loans, advances, and certain off-balance sheet items such as trade finance, foreign currency transactions, forward contracts, derivatives, and letters of credit. The risk can be reduced by establishing proper underwriting and monitoring procedures, as well as utilizing collateral to secure loan payments in the event of default.

There are many types of credit risks that can be incurred by banks, including:

Counterparty credit risk arises from trading activities such as acceptances, interbank lending or any kind of trade finance, and foreign exchange transactions. It can also be derived from exposure to a single industry sector (concentration risk) or a specific country (sovereign risk). A financial institution may mitigate this type of risk by restricting lending to a limited number of borrowers, requiring substantial collateral, and/or establishing strict debt covenants. This can also be achieved through the use of guarantees from third parties, such as commercial insurance or deposit insurance.

Market Risk

Market risk is the possibility that a financial institution will lose money from changes in financial markets, such as fluctuations in stock prices or the price of a commodity. It can also come from interest rate changes or the exchange rates of currencies.

The primary measure of market risk is value-at-risk (VaR), which all banks are required to report and hold capital against. VaR models use a variety of assumptions, including the horizon of time for which the model is run and the EWMA smoothing constant. Showing how VaR models behave in benign and stressful periods can highlight the messages that these models are giving to fi nancial institutions.

While it is difficult to eliminate market risks completely, they can be mitigated through diversification and the selection of investments with low correlations with each other. In addition, financial institutions should be encouraged to test their risk management systems using stress scenarios, and disclose details of those tests publicly. These disclosures can help other financial institutions make better decisions about their own risk appetite and risk management practices.

Liquidity Risk

Financial institutions need access to funding to pay short-term debts, meet daily operations, and invest in long-term projects. Liquidity risk is the potential for these companies to run out of cash and not be able to meet their debt payments without incurring unacceptably large losses. Liquidity risks can result from relying too heavily on short-term sources of funds, or from having a balance sheet that is too focused on illiquid assets that cannot easily be converted into cash.

The liquidity risk can also be caused by poor asset-liability management, which creates a mismatch between the maturities of assets and liabilities. This can cause financial firms to be more vulnerable to changing market conditions, such as when rising interest rates drive out deposits or lower the value of fixed income securities.

To reduce the risk of liquidity issues, a strong governance structure is important for financial institutions. This includes having clearly defined roles for risk management and frequent communication between risk managers and senior management. It also involves minimizing the amount of money that is invested in illiquid assets, and focusing on having cash on hand to cover expenses.

Operational Risk

Losses from operational risk arise from inadequate or failed internal processes, improper business practices, systems failures, and adverse external events. Such losses can be direct or indirect, and can impact the current and projected financial condition of a bank. Direct losses from operational risk include check fraud, product flaws, theft, bribery, and other forms of misconduct. Indirect losses include a loss of customer confidence that may lead to a “bank run” in which customers withdraw their deposits and cause the bank to lose funds and possibly fail.

In recent years, the scope of operational risk has expanded as banks face new challenges. For example, as banks rely more on third parties, they must manage third-party risks; digital transformation has created technology risks that need to be managed through analytics and real-time monitoring; and the lines between frontline groups and risk teams are becoming more blurred. In addition, specialized risk types such as cyberrisk and conduct risk are generating additional demands on risk teams’ time. These trends are driving a need for a more holistic approach to operational risk management that incorporates second-line functions and a broader set of data sources.

Legal Risk

Legal risk is the threat of monetary losses or loss of reputation from failure to abide by laws, regulations and best practices. It may be the result of mismanagement, administrative errors, or customer dissatisfaction. Financial institutions must also consider the potential to engage in illegal transactions such as money laundering, terrorist financing and financial fraud, which could lead to fines and penalties, a decline in market position, or the restriction of growth opportunities.

Legal and compliance risks are distinctly different from other types of risk such as credit, liquidity and operational. The governance practices that work well for those risks are unlikely to work for legal and compliance.

This is why the legal function needs to take the lead in promoting the understanding that its risks are distinctly different from those of other functions. Until this is done, legal risk may continue to be overlooked. This is not good for the financial industry, nor for individuals who depend on its services. It is also not good for the reputation of the legal profession. It’s time for a change in perspective.

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